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Brooks Wilson's Economics Blog: The Tax Cut Compromise

Monday, December 13, 2010

The Tax Cut Compromise

The United States is mired in the drag ends of the recession caused by the financial crisis.  Our slow motion recovery has left labor markets week; unemployment currently flat lines at 9.8% with few prospects of rapid improvement.  The Fed has been aggressive in pursuing easy money policies, and thus far, the Obama administration and its Congressional allies have used fiscal stimulus, deficit spending, to combat low demand.  The November elections gave Republicans voice, and they prefer policies that keep marginal tax rates low, a long term growth plan.  Both the administration’s and Republicans’ plans would expand the deficit and national debt.  

The financial crisis, the ensuing bailouts, and the attempt to stimulate the economy through fiscal stimulus created a yawning deficit at a time when aging baby boomers’ demand on Social Security and Medicare are expected to create unsustainable deficits.  Most(1) economists agree that the government must bring the budget under control to avoid a fiscal crisis similar to that facing several European countries.  There is disagreement as to how to achieve this goal, but the government has three tools: it can cut benefits, raise taxes, and reform the programs to increase efficiency.  Economists who deem traditional fiscal policy effective generally believe that raising taxes or cutting benefits slow economic activity.

Policy makers and the economists who advise them must decide how to deal with the two problems.  Many economists believe that the government has a one to two year window of opportunity to use fiscal policy to boost demand for goods and services.  A great many other economists believe that the government should focus on the deficits and growing national debt first. The Obama administration and Congressional Republicans compromised on extending Bush era tax cuts for an additional two years.  The administration agreed to extend tax cuts for all Americans, including the wealthiest 2%, and lower the increase in the estate tax from 45% to 35% on estates greater than $5 million.  In return, Republican negotiators agreed to extend unemployment for an additional 13 months and lower employee taxes 2% for two years. 

The administration has placed its chips on stimulating demand by running deficits.  I believe this policy is risky because empirical support for fiscal stimulus is weak, and it creates even larger deficits and national debt as we enter a period of unsustainable levels of deficits and debts. 

The Republican negotiators have placed their chips on low marginal tax rates, a desirable condition for long term growth.  Many conservative pundits have suggested that the increased growth from the tax cuts will generate sufficient tax revenue to compensate for lost revenue from the tax cuts.  Few economists, even among those who favor extending the tax cuts, believe that they will generate net revenues.

Like most economists, I have problems with details of the compromise; after all, we like our ideas best.  I prefer low tax rates, institutional reform of Social Security and Medicare designed to strengthen market incentives, and budget cuts—large budget cuts. 

I could support the compromise if legislators avoid attaching other pork filled measures to the legislation that would further widen the deficit and expand our national debt.  It currently does not.  The Senate bill includes a one year extension of renewable energy grants that subsidize renewable energy companies (“Senate bill includes clean energy grant renewal”).  The bill also includes an extension of the 45 cent-per-gallon tax credit for blending ethanol and gasoline (“Senator Feinstein: Ethanol Tax Credit Included in Tax Compromise”).  If these renewable energy sources were worthwhile, they would not need subsidies from the government.  American economic might cannot be built on high cost energy.  

(1)  This is a weasel word alert.  I have been free with my use of weasel words like “most” and “many” because I have no idea as to where the consensus rests, but I believe that all the positions I describe are mainstream.

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